Introduction to derivatives
We’ll be outlining the main features of the key derivative products, these concepts are generic, and common for all asset classes (e.g. Equities, FX, Fixed Income, Credit etc..).
We’ll dig further into the particularities of each asset class; how to price them, hedging strategies and exotic variants.
For example, holding some equities can yield a dividend, that is not included in the market price. Holding fixed-income can generate an interest that may be included (dirty price) or not (clean price) in the market price. Holding commodities might have a storage-cost, that is closely related to the concepts of contango and backwardation.
A forward contract fixes today the price of an asset delivered in the future.
Forwards are contracts that are “Over The Counter” (OTC); this means that they are negotiated between the buyer and the seller.
The contract can be terminated early for a “break” amount if that is part of the agreement.
Futures are similar to forwards, but they are negotiated in an exchange.
The futures contracts are standardized in terms of size, units, trading hours, delivery type, margin requirements etc..
Margin requirements are a feature of futures and might imply dealing with additional cashflows.
In a swap contract, two parties agree on exchanging cash flows based on different indexes; usually, one leg of the contract is a fixed rate while the other one is variable or floating.
Swaps are OTC products, they usually start in two days from the spot, but they can also come effective in the future, in this case, they are called forward starting swaps.
The convention in swap contracts is that the buyer is the one receiving the variable cash flows.
In a forward or a futures contract, the buyer agrees to pay a fixed price in the future.
With options, you can buy the right but not the obligation of purchasing an asset in the future at an agreed price.
The right to buy an asset is a “call” option, and the right to sell it is a “put” option.
The forward price at which the asset will be possibly exchanged is the “strike” price.
Options similar to futures can be physically exchanged, or cash-settled, meaning that you might need to deliver or you may receive the asset itself.
There are different types of options; the main three are:
- European: The bondholder can only exercise the option on the maturity date.
- American: The bondholder can exercise the option at any time before or on the maturity date.
- Bermudan: Allows the holder to exercise on pre-agreed dates.